Take the lead: Diversifying with credit

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Advisors: talk with your clients about the potential value of diversifying their fixed-income exposure, especially if they’re reliant on tracking the Agg.

The background

Investment-grade bonds have long been the choice of fixed-income investors looking for high-quality sources of income and capital preservation. And products that track the Bloomberg Barclays U.S. Aggregate (the Agg) exploded in popularity after successfully delivering on both objectives for years. But the Agg is heavily concentrated in government securities, which can mean increased risk and lost opportunities for fixed-income investors.

How investors can approach diversifying with credit

  • Understand the risks of tracking an index that is concentrated in government bonds.

While it may seem well-diversified on the surface, the Agg’s concentration in government-guaranteed debt ensures that interest rates remain the driving force behind performance. Unfortunately for investors, compensation for that risk is near an all-time low.

  • Aim to boost portfolio yield with a prudent level of credit risk.

Given a background of low interest rates and an index largely composed of government bonds, investors tracking the Agg are not getting very attractive yields compared with many other fixed-income options. Incorporating credit in a portfolio can boost yields.

  • Look to the past. Historically, credit-based sectors have proven to provide better income and return opportunities.

Many investors assume that introducing credit alongside high-quality, core bonds results in a riskier portfolio. But credit risk and interest-rate risk are negatively correlated and react differently to various market catalysts. This diversification may mitigate portfolio drawdowns from poor performance by a single risk factor.

  • Consider a variety of options to gain credit exposure.

A range of credit instruments outside the confines of the Agg may appeal to investors, including high-yield bonds, mortgage- and asset-backed securities, and emerging markets debt, but a flexible approach to allocating among these instruments is required, as opportunities and risks within these sectors shift.

  • Learn more about the three sources of credit exposure.

When targeting credit risk, investors can choose among three distinct balance sheet types that have varying degrees of sensitivity to economic and market cycles. Corporate credit tends to outperform as business activity accelerates and the economy expands. Consumer credit is beneficial when personal incomes and asset prices rise. Sovereign credit thrives when economic growth and fiscal policy improve.